 Income tax 2021-2022. Depreciation of rental property part number one. Get ready to get refunds to the max. Diving in the income tax 2021-2022. Most of this information can be found in publication 527 residential rental property tax year 2021 on the IRS website irs.gov, irs.gov. Income tax formula line one income. We would then have a sub schedule that basically being an income statement with income and expenses, the expenses basically being deductions. The net then is what rolls into line one income of the income tax formula, as well as eventually the page one of the form 1040. This is the schedule E in essence, the income statement, the supplemental income and loss were focused in on the rental real estate. So we're looking at depreciation of the rental property. You recover the cost of income producing property through yearly tax deductions. You do this by depreciating the property that is by deducting some of the costs each year on your tax return. Now note depreciation itself is basically an accrual concept. So even if you're on basically a cash basis method, the tax code will require us at some points to be moving to an accrual concept. So even if we paid all cash for the rental property, then we still have to record it on the books as an asset as opposed to simply expensing it as just basically rental building expense when we purchase it because it's a substantial investment that's gonna be benefiting us into the future. And therefore we have to put it on the books as an asset and allocate the cost over the useful life, the useful life in essence being determined by the tax code in this case. So clearly that's gonna be a significant component when we calculate the taxes and when we do planning with regards to real estate investments. So three factors determining how much depreciation you can deduct each year. Number one, your basis and the property. So the basis is kind of like the adjusted cost of the property. So you purchase the property, that would be the major kind of component of the basis. And then you got basically adjustments from that point. Number two, the recovery period for the property. So how long is the recovery period? Meaning in depreciation terms for generally accepted accounting principles in any case, that would be like the useful life. How long are you gonna allocate basically the cost over? And you're not gonna do that allocation most likely. What you'll do it in accordance with the tax code. And then three, the depreciation method used. So what kind of method are we using? That then will be determined in large part by the tax code. What will the tax code allow us to depreciate? So common kind of accounting depreciation methods would be like double declining or a straight line method or the two most common methods double declining is an accelerated method. And typically if we can get an accelerated method we would like to that would allow us to deduct more on the front end than on later years. And for taxes deducting earlier is generally more beneficial than getting the deduction later. But we're restricted to what the tax code says with regards to the type of property we have, how long we have to depreciate that over how many years in other words, and what will be the type of depreciation method we are allowed to use. So you can't simply deduct your mortgage or principal payments or the cost of furniture fixture and equipment as expenses. So these large kind of items that are gonna be benefiting you for substantial periods into the future those are the items that you would typically need to be putting on the books as an asset that would include the property itself and other large kind of costs that you would have furniture, fixture, equipment, and so on. You can deduct depreciation only on the part of your property used for rental purposes. So if you're talking about property that has both a personal and business use to it in common kind of things here. So if you're rendering out like your home that's gonna be an issue with regards to what amount of it could be depreciated whenever you have a car, if you're using the actual method, how much of it can be depreciated if it's business and personal use and so on and so forth. So depreciation reduces your basis for figuring gain or loss on a later sale or exchange. You may have to use form 4562 to figure and report your depreciation, see which forms to use in chapter three. Also you can see publication 946 for more detail. We got the section 179 deduction. This is an accelerated type of method. Note that the tax code is not here as is normal financial accounting bookkeeping records in order to keep our financial statements recorded in a way that is most representative of the business even though depreciation isn't a cruel concept. The depreciation could be altered, in other words, to serve other purposes such as stimulating the economy for example, one way they like to stimulate the economy is allow people to take more of the depreciation costs upfront which is hopefully gonna put more cash in the economy. They might, we'll see what happens with these laws in the future because the economy seems to be overheated at this point. So you could have changes to these. They've been quite, quite aggressive on the accelerated depreciations. So the section 179 depreciation is a means of recovering part or all of the cost of certain qualifying property and the year you place the property in service. It is separate from your depreciation deduction. C chapter two of publication 946 for more information about claiming this deduction, alternative minimum tax, the good old AMT, the Ampt. So if you use accelerated depreciation, you may be subject to the AMT alternative minimum tax. Accelerated depreciation allows you to deduct more depreciation earlier in the recovery period than you could deduct using straight line method, same deduction each year. So in other words, if you can use an accelerated method that would typically be beneficial for taxes because that means you're going to be deducting not an even amount over the useful life or the life of your allocation of the cost, but rather more in the front end. You're front loading the items, meaning you're getting the benefit upfront which is typically good for taxes, but they might say, hey, alternative minimum tax is gonna stop you from getting that quite so beneficial benefit from that in some instances. So the prescribed depreciation methods for rental real estate aren't accelerated so the depreciation deduction isn't adjusted for AMT. So when you talk about the real estate itself, you're typically already using the straight line. Why? Because they make you. So there's not gonna be an adjustment for that one. However, accelerated methods are generally used for other property connected with rental activities, for example, appliances and wall-to-wall carpeting. So some other items that you might have the capacity to use the accelerated methods. And if you do, then you could run into the AMT at some point. To find out if you are subject to the AMT, you can see instructions for form 6251, the basis. The following section discusses the information that you will need to have about the rental property and the decisions to be made before figuring your depreciation deduction. So the basis is kind of like the cost that, you know, when you first buy it, like it's gonna be the cost, but then there's questions as to what should be included in the basis. What do you need to capitalize in the basis as opposed to things that you can expense upfront. When you're talking about the purchase of real estate, for example, that gets kind of complex because you've got a lot of stuff going into the actual purchasing process. You gotta go through the escrow process. You gotta pay a bunch of people how much of that stuff is deductible upfront and how much of that stuff is the cost of the property that you're purchasing that you have to capitalize. Now note, as you're thinking about these costs, these are usually things that will happen upfront or at the purchase time, once you've figured it out, it's gonna be easier to do your taxes after that point. But so you have to kind of figure this allocation upfront. Also note, it would be more beneficial. What you would like to do is record something as an expense as opposed to including it in the cost or the basis, because if you include it in the cost or the basis, then you don't get the expense upfront, but you have to allocate it over the life, whatever life the tax code forces you to do. So you have to follow the law on that, but you wanna think in your mind, always with the taxes, pretty much the general rule is pretty much I'd like to get the deduction sooner is the general rule unless exceptions apply. So what rental property can be depreciated? You can depreciate your property if it meets all the following requirements. You own the property. You use the property in your business or income producing activity such as rental property. So it's your property, yeah, it's your property and you're using it for the business purpose. The property has a determinable useful life so we can determine what the useful life is. The property is expected to last more than one year, which most real estate property you would think. What property you own to claim depreciation, you must usually be the owner of the property. You are considered to be the owner of the property even if it's subject to a debt. So note that people often say like, well, the bank owns like 80% of my property. That's not really true even though you have a loan with the property that's as collateral. And you can tell that because if you're voting like in your home and you're saying, what color should we paint our house today? It's not like the bank can come in and say, hey, I have my 80% share and I wanna paint it blue. They can't do that, right? Because they don't own the home. They have recourse if you don't pay off the debt. That's gonna be a different type of thing. So even though you own a loan, that doesn't mean like the bank owns the home, they have recourse in the event that you default on the payment of the loan. They don't have any kind of say on what you do with the home unless that happens. So rented property, so generally if you pay rent for a property, you can't depreciate that property. Usually only the owner can depreciate it. So if you're renting and you're paying rent, then you don't own the home, but you might be able to deduct rent if it's part of a business or something like that. But then that would mean you don't own the home. So you're not gonna have depreciation in that case. So however, if you make permanent improvements to the lease property, you may be able to depreciate the improvement. So you may have a long-term lease of the property and then you make a substantial improvement to it and you couldn't deduct it, but rather you have to put it on the books as an asset and depreciate it, then you might have depreciation even though you're renting. See additions or improvements to property later in this chapter under recovery periods under GDS. Corporative apartments. If you are a tenant and stockholder in a corporative housing corporation and rent your corporative apartment to others, you can depreciate your stock in the corporation. You can see chapter four in that event. Property having a determinable useful life. To be depreciable, your property must have a determinable useful life. This means that it must be something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes. Everything does except basically land for us, meaning a property we hope goes up in value. But obviously if we did not upkeep the property, then it would depreciate over time. It would get obsolete. It would lose its value. It would deteriorate. The thing that doesn't is the land. The land is the thing that in human life spans will be pretty much the same. The dirt is the dirt. And you can kick the dirt. You can, it's not gonna go away. You're not gonna depreciate the dirt, but it might change in value, but it's not gonna be going away. So we don't really record the depreciation possibly for that component, the amount allocated to land. And that's gonna be always another important allocation when you purchase something. How much is attributable to the dirt, to the land itself versus the structure versus the building, because the building will depreciate over time. The land will not. So from a tax perspective, we would like to allocate more to the building because the building will give us a deduction whereas the land's gonna kind of be stuck up there and we're not gonna get the deduction from it until the point in time we'll get a tax benefit. When we sell the property at some point, but we wanna get it like sooner, we wanna deduct it. So what winter property can't be depreciated? Certain property can't be depreciated. This includes land and certain exempt property. So again, land can't be depreciated. So every property, so you might just buy land if you just bought land, then it's just land and there's nothing on it. Well then maybe the land's hoping you're helping the land goes up in value or something like that. You're not gonna depreciate it because the land doesn't go away in human lifetimes if the land is just sitting there. It is what it is. It's not deteriorating, hopefully, unless whatever. But if there was a building on it, then you got land and building combined together and now you gotta say, well I only paid one price for that. How much is allocated to the land? How much is allocated to the building? You'd like to allocate more to the building possibly because the building would be depreciable but you gotta allocate fairly between the land and the building somehow. So you can't depreciate the cost of land because land generally doesn't wear out, become obsolete or get used up, right? The land is what it is. But if it does, the loss is accounted for upon disposition. The cost of clearing, grading, planting, landscaping are usually all part of the cost to the land can't be depreciated. So in other words, if there was something on the land that you needed to tear down, then you're not talking about something that's depreciating over time, that's actually part of the land, which is a little funny. So once again, the cost of clearing, you're clearing the space, grading the space, planting and landscaping are usually all part of the cost of the land and can't be depreciated. So you may, however, be able to depreciate certain land preparation costs if the costs are so closely associated with other depreciable property that you can determine a life for them along with the life of the associated property. For example, you build a new house to use as a rental and paid for the grating, clearing, seeding and planting bushes and trees. Some of the bushes and trees were planted right next to the house, while others were planted around the outer border of the lot. If you replace the house, you would have to destroy the bushes and trees right next to it. So the bushes and trees are closely associated with the house, so they have a determinable, useful life, therefore you can depreciate them. So it gets a little in the weeds, they're a little tricky. But the strategy from a tax standpoint would be, I would like to get things in the category of being able to depreciate them as opposed to not being able to depreciate them. And that's the lens you're typically looking through when you're considering these kind of things. So add your other land preparation costs to the basis of your land because they have no determinable life and you can't depreciate them. So accepted property, even if the property meets all the requirements listed earlier under what rental property can be depreciated, you can't depreciate the following property. Property placed in service and disposed of or taken out of the business use in the same year. Equipment used to build capital improvements, you must add otherwise allowable depreciation on the equipment during the period of construction to the basis of your improvements. For more information on that, you can see chapter one in publication 946. When does depreciation begin and end? You might ask, when does it start? When does it finish? If I have to put this thing on the books and capitalize it and I can't depreciate it right away when what's the whole beginning and ending date of this whole process? How long do I have to allocate these costs over? You begin the depreciation, your rental property when you place it in service for production of income. So when you put it in business, that's when it generally starts for the production. You stop depreciating it, either when you have fully recovered your cost or other basis, or when you retire it from service, whichever happens first. Now this first one, you begin depreciating your rental property when you place it in service. Obviously, if you just bought a rental place for renting it, then it would be pretty straightforward. You bought it to rent it at that point in time. If you build a piece of property, then it gets a little bit more confusing because now you're building it and you would think that once built and you put it in place, that's when the depreciation kind of takes place. If you're converting something, or if you had like a home that you're converting to a rental, then you have the home, which you weren't depreciating before because it was a personal residence, although you might still get a benefit from something like mortgage interest and property taxes, you don't typically depreciate the personal residence and then you convert it to rental property. And that's the point in time, you might have to put it, you basically be depreciating, which gets more confusing at that point because now you didn't just purchase it, it might be a little bit more confusing to determine, you gotta figure out what the basis and what not would be to depreciate it at that point. Obviously depreciation stops when it becomes fully depreciated. So if you've gone past the life expectancy, the useful life, or whatever the tax code told you to depreciate it over and you've passed that timeframe, which can be quite extensive timeframe, then you would have all allocated all the basis out. You would have expensed it over that timeframe, gotten the benefit of the cost over that timeframe and you would stop depreciating it because it would have been fully depreciated. You would have realized in some time period the benefit of the cost of it or if you were to sell it or something like that basis when you retire it from service or you stop using it as rental property or something like that.